Most Expensive Place to Find Out Who You Are

The year has gotten off to a tumultuous start for U.S. stock investors. The Dow Jones Industrial Average has swung up or down at least 100 points during the day on 25 out of the 26 trading days so far this year. Between Jan. 15 and Feb. 3, the S&P 500 fell 5.8% before seeming to stabilize in the middle of this past week.

But that didn’t make stocks cheap. At the end of last year, U.S. equities were trading at 25 times their average earnings over the past decade, adjusted for inflation. At the recent low on Feb. 3, that was down to 24.2—still far above the long-term average of 16.5, according to data from Yale University economist Robert Shiller.

What should you do? Individual investors should tune out the futile efforts by commentators and strategists to extrapolate the market’s latest swings into a prediction of what will happen next. Instead, use the recent volatility to make an honest reassessment of what kind of investor you are and how much risk you can stomach.

The financial writer “Adam Smith” (the pen name of George J.W. Goodman), who died last month, once wrote, “If you don’t know who you are, this is an expensive place to find out.” In fact, he wrote it twice, in his sparkling best seller “The Money Game,” first published in 1968. The italics were in the original; by “this,” he meant “the stock market.”

If you have been glued to financial television or websites, fixated on the sight of falling arrows and reddening charts, then this year’s short-term turbulence already has told you something about yourself that has enormous long-term importance: You probably have too much in stocks.

If you feel rattled by a pullback of a couple hundred points on the Dow, then you are kidding yourself if you think you can withstand a drop of a few thousand points when it comes. The Dow fell from 14000 in July 2007 to below 7000 in March 2009 — a collapse that many investors have willfully forgotten already. Sooner or later, something at least as bad will happen again.

Mind you, much of what has felt recently like turbulence is little more than a statistical illusion. People are prone to what behavioral economist Richard Zeckhauser of Harvard University’s John F. Kennedy School of Government calls “denominator blindness”: We focus intently on swift and vivid changes but overlook the base against which we should measure them.

Consider a 150-point swing in the Dow. It feels striking even though, with the Dow close to 15800, it is less than a 1% change.

On Oct. 19, 1987, it took a decline of 508 points to chop 22.6% off the Dow. If the Dow dropped 508 points from this past week’s close, denominator blindness would make the drop seem acutely frightening—even though it would now amount to just a 3% loss, something that has happened 37 times since the beginning of 2008.

The financial industry has traditionally sorted investors into three types: conservative (willing to tolerate very little risk of loss), moderate (willing to take some risk) and aggressive (prepared to withstand high risk).

Benjamin Graham, the founder of modern investment analysis and author of the book “The Intelligent Investor,” after which this column is named, didn’t believe in differentiating people that way.

Instead, he divided investors into two types: defensive and enterprising.

Defensive investors, Graham argued, want to avoid “serious mistakes or losses” and seek “freedom from effort, annoyance and the need for making frequent decisions.”

Conversely, wrote Graham, enterprising investors are willing “to devote time and care to the selection of securities that are both sound and more attractive than the average.”

If you are an enterprising investor, then you should monitor the financial markets carefully in the hope that a substantial fall will present bargains. “These price changes that we have seen so far [in 2014] aren’t sufficient” to make stocks cheap, says Michele Gambera, head of quantitative analysis at UBS Global Asset Management in Chicago. He reckons that U.S. stocks would have to fall about 15% from here to be attractive.

But if you are a defensive investor, you should monitor yourself carefully.

If you aren’t bothered by the latest gyrations, then there isn’t any compelling reason for you to change course. Mildly overpriced markets often have produced decent returns in the past; on average, only at much higher valuations have stocks gone on to generate poor returns, research at London Business School has shown.

If your financial adviser is urging you to make a sudden move, be sure to ask whether he counseled clients to get out of the market in 2008 and 2009 or to buy more as stocks got cheaper. If he advised clients to get out, when did he tell them to get back in?

On the other hand, if you have been staring every time the Dow pulled off a triple-digit move this year, then you should consider trimming back on your stocks in favor of cash and bonds. You don’t want the next decline to be an even more expensive way for you to find out who you are.